Have you created your retirement plan yet? It’s probably not too late to start. If you want a comfortable retirement, you can’t simply rely on your Social Security benefits. Instead, you must plan ahead and create a comprehensive retirement plan that will meet your future needs and allow you to relax comfortably in your golden years. Individual Retirement Plans (IRAs) are an easy way to start your plan while saving and investing in your future.
How an IRA works in retirement planning
An IRA, or individual retirement account, is basically an investment account with various tax benefits. An IRA provides a dependable way to set aside money for retirement. With individual IRAs, you do not have to pay taxes on the earnings from the retirement account. Those earnings can instead be reinvested in order to allow your account to grow exponentially. Then after you reach retirement age and begin to make withdrawals, your tax obligation will depend on the type of IRA you own, your current income and the amount of your withdrawals.
Understanding the various types of IRAs
There are four kinds of IRAs with various benefits. Traditional and Roth IRAs are established by individuals, whereas Simplified Employee Pensions (SEPs) and Savings Incentive Match Plan for Employees (SIMPLE) are sponsored by employers. Regardless of the type you choose, all IRAs are “fully vested.” This means all of the contributions you make and earnings you accumulate belong to you.
Limitations on contributions depend on the type of IRA
The IRS has established limitations on the total amount of annual contributions you can make to an IRA account. These limitations are subject to change each year. For that reason, you should always consult with your retirement planning attorney to determine the current limitations for that year.
In 2016, the maximum contribution for both Traditional and Roth IRAs is $5,500, for individuals under the age of 50. For those over age 50, the limit is $6,500. The maximum contribution for an SEP IRA is $53,000. The limit for a SIMPLE IRA is $12,500 if you are under age 50 and $15,500 if you are older.
Characteristics of a traditional IRA
A traditional IRA is funded with what is referred to as “pre-tax” dollars. This means you are not required to pay any taxes on your contributions or the interest they earn until you begin taking withdrawals at retirement. At that point, each withdrawal you make is taxed as regular income. For example, if you owe 20% tax on your income based on your income and you take a withdrawal of $10,000 during the tax year, you will owe $2,000 in federal and state income tax.
Characteristics of a Roth IRA
A Roth IRA, however, is funded with “after-tax” dollars. This means that a Roth IRA does not provide tax benefits when it comes to contributions. Instead, the earnings and withdrawals from Roth IRAs are typically tax-free. A major advantage to a Roth IRA is that not only are your earnings allowed to grow tax-free but when you retire and take withdrawals, you pay no income taxes. In essence, you avoid taxes when you contribute to the traditional IRA, but you avoid taxes with the Roth IRA when you withdraw money at retirement.
Early withdrawal penalties for IRAs
Regardless of the type of IRA you have, you will be subject to an early withdrawal penalty if you take distributions before you reach the age of 59½. With a traditional IRA, the penalty is an additional 10% on top of the income tax you are required to pay on distributions. The Roth IRA also requires that you have owned your IRA for at least five years before you start taking distributions, or else you are charged a penalty. A benefit of a Roth IRA, though, is that you can withdraw your original contributions at any point without penalty. The reason is you have already paid income tax on those funds.
Maximum contributions to employer-sponsored IRAs
The employer-sponsored IRAs (SIMPLE and SEP) are available for employers who meet certain criteria, including self-employed individuals and small business owners. The maximum contribution an employee can make to a SEP IRA is $53,000. The maximum contribution to a SIMPLE IRA is $12,500, if you are under age 50, and $15,500 if you are older than 50.
Join us for a free workshop! If you have questions regarding individual retirement accounts, or any other retirement planning matters, contact Gaughan & Connealy for a consultation either online or by calling us at (913) 262-2000.